What is Negative Equity?

If you have ever taken a loan, you might have heard the word negative equity and positive equity before now but what exactly do they mean, and what is their impact on a person or entity? Before we delve into discussing what is negative equity, let us understand what equity means.

Simply put, it is owning an asset or assets especially when the assets have some liabilities or debts associated with them. Hence in order to measure or gauge the equity of an asset, the value of the liabilities associated with it is deducted from its value.

Now that we have an understanding of what equity means, let us have a look at negative equity.

When this happens, it results in negative equity for the person or entity that owns the asset; they are also said to be underwater.

Types of negative equity

1. Negative equity for companies or negative shareholder equity
2. Negative equity for assets
3. Negative equity for individuals

Negative equity can occur in any of the three ways listed above. We shall have a closer look at each of these ways below:

For companies

When equity is negative for a company, it is termed negative shareholder equity. The negative shareholder equity describes a situation in which the company’s liabilities are more than its assets; this may happen when a company has:

• Incurred a consistent and significant amount of losses that are greater than its earnings.
• Made dividend payments to its shareholders such that its combined retained earnings and other assets are lesser than its liabilities.

Simply put, negative shareholder equity is when a company’s balance sheet is skewed and unbalanced due to the liabilities side being greater than the assets side. This is usually an indicator of financial distress which if not properly managed could lead the company into bankruptcy and in severe cases, liquidation.

For assets

A lot of people take out a loan when they want to purchase a car or house and any event that leads to a reduction in the value of these assets results in negative equity for them. For cars, it is common knowledge that their value begins to depreciate the moment it is driven out of the car dealership, additionally, rapid and consistent use could also contribute to its depreciation since the mileage covered within that short time frame of rapid use is likely to be very high. For houses, prices could undergo a significant decline either because the part of town where the property is located has experienced some kind of natural disaster, an increase in crime rates, a decline in the number of people seeking property within that location, or a housing bubble burst. These aforementioned factors have made the automobile and real estate sectors to be the most commonly affected sectors when it comes to negative equity for assets since those situations typically lead to a reduction in the value of the car or house.

Another concept that is closely related to the negative equity for assets is negative amortization; this is a situation whereby the value of the asset does not change but the outstanding balance on the loan that was taken to purchase it increases mostly because the borrower has not made sufficient loan repayments.

For individuals

Individuals can also experience negative equity and a lot of people do experience it, especially those who have had to use student loans to finance their education. People who take out personal loans, credit cards, and all other types of loans can also have negative equity. Just as is the case for negative equity for a company, any individual whose liabilities are greater than their combined assets is said to be experiencing negative equity or has a negative net worth.

Negative equity vs positive equity

We have seen that negative equity is when the current market value of an asset is lesser than the remaining balance on the loan taken to acquire it. Positive equity on the other hand is when the current market value of an asset is higher than the remaining balance on the loan taken to acquire it.

For example, if you want to purchase a house worth $1,000,000 but you do not have enough money to make this purchase and you decide to take a mortgage to finance the house. If the interest rate on the mortgage is 7% and the tenure of the loan is 8 years, you can have either positive or negative equity.

If after three years the price of houses experiences an upward increase and the current market value of your house is $1,300,000 while the outstanding balance of your mortgage is $600,000. It means you have positive equity since the difference between the current market value and the outstanding balance is $500,000 which means your asset is greater than your liability.

Conversely, if the price of houses experiences a decline and the current market value of your house after three years is $500,000 while the outstanding balance on your mortgage is $600,000. It means you have negative equity since the difference between the current market value and the outstanding balance is $100,000 which means your asset is lesser than your liability.

Frequently asked questions

Conclusion

Being underwater without any breathing gear is a terrible experience, that is exactly what having negative equity either as a company or individual or on an asset you own means. In order to avoid this very discomforting situation, it is important that one does not falter on loan repayments and tries as much as possible to take only loans that can be fully repaid within the stipulated time frame without having to experience your assets being of lesser value than your liabilities. Companies should also ensure they develop fail-proof business strategies that can stand the test of time and various economic conditions. Furthermore, if they pay dividends on the stocks they issue, they should make sure that the dividend payments made do not exceed their combined retained earnings and assets.